The insurance bailout

The whole debacle with the US housing market, and, in particular, the bailout of Freddie and Fannie, raises some very important questions as to what the role of government should be in supporting the economy. Proponents of the bailout argue that Freddie and Fannie are so central to the operation of the US mortgage market that their collapse would spell an economic catastrophe. However, my fear is that the alternative – a bailout – while attractive in the short term, could be far more catastrophic in the long term. Specifically, a bailout skews the risk analysis by companies, since they come to assume that if they run into trouble the government will bail them out. This in turn encourages irresponsible risk taking behaviour, which, in the long term, will lead to the same problem of over exposure to risk arising again and again. So as a rule of thumb I tend to oppose bailouts, no matter how dire the situation may appear in the short term. One of the most pivotal aspects of a market system is that market participants need to take responsibility for the risks they take. This in turn encourages responsible risk taking. Bailouts (or any other form of government backing) completely destroy this important feedback mechanism.

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